Global Investment and Finance: Stock Options

GLOBAL INVESTING AND FINANCE: DO YOU ALWAYS KNOW THE COMPANY? January 7, 2002

Trading and investing without regard to national borders is now commonplace and, depending on who you talk to, is either the salvation to or the death knell of the American economy. For companies seeking to grow and investors looking for new investment opportunities, it is important that everybody plays by the same accounting and finance rules. The Enron debacle has proved beyond doubt that clear accounting standards matter.

In the United States, the Financial Accounting Standards Board (FASB) sets the rules for accounting practices. Beyond U.S. borders, the newly formed International Accounting Standards Board (IASB) is undertaking the same mission. There is widespread, international support for harmonizing accounting standards. Uniform standards can reduce the cost for multinational corporations in complying with varying rules and allow investors to obtain the financial information necessary to make informed and valid comparisons. For example, differing French, American and British accounting methods can complicate international business decisions. It is important to understand how companies, no matter where they are located, report earnings. Investors and analysts would welcome standards that would allow them to have confidence in all businesses wherever they are. The IASB’s success will be measured by the widespread acceptance of the standards it develops.

One of IASB’s the first proposals is controversial — an international standard of stock-option accounting that would require companies to recognize the fair value of outstanding employee stock options as an expense in their financial statements. This issue was resolved for the United States by FASB only six years ago. While to many this may seem a dry issue, it could have an enormous impact on entrepreneurial companies trying to leverage their assets and grow quickly.

Why is this issue so important for American business? Stock options are granted to employees for many reasons: for new companies they offer a way to entice talented managers and knowledge workers to joint a start-up when dollars are in short supply; for many companies, stock options provide an incentive for employees to feel invested in their companies (as owners are); and for some companies stock options are used to motivate and compensate top managers.

According to experts, the FASB rule adopted in 1995 has enabled millions of American workers to share the wealth created in the 1990s. Stock options enabled employees to buy homes and send their kids to college. While stock options are undergoing increased scrutiny because of the recent downturn in the market, no one is suggesting that stock options are no longer attractive — only that companies need to be up-front about their inherent risks and rewards. Where the issue becomes controversial is how companies report to their shareholders the amount and value of stock options they have authorized.

This controversy came to a head in the United States, in 1993, when FASB proposed that all stock options should be assigned a fair value on their date of grant to eventually be recorded by companies as operating expenses. Many members of Congress and many corporate executives vigorously opposed this proposal, citing the inadequacy of accounting standards to establish a “fair value,” especially for those stock options that do not vest for several years and cannot be freely traded. Current option pricing models overvalue employee stock because they do not take into account these limitations. Accountants argue that by trying to include all these variables into a formula to value the stock options, they are introducing subjective judgments on a balance sheet.

This overvaluation of stock options could be detrimental to new, growing companies because entrepreneurial firms rely so heavily on employee stock options. Expensing these options would yield financial statements much less attractive than those of non-entrepreneurial companies in the same industry group. This issue became so volatile in 1993 that 3,000 employees rallied in Silicon Valley while wearing “Stop FASB” t-shirts. In 1995, FASB settled the issue by adopting a “disclosure-only” alternative that would require companies to report the value of the stock options they issue if they do not account for them as an operating expense.

According to a large, blue-ribbon consortium of businesses and business organizations, (including Apple Computer, Cisco Systems, Motorola, the American Electronics Association, the U.S. Chamber of Commerce, the National Venture Capital Association, the Printing Industries of America, and the Software and Information Industry Associations), the disclosure-only alternative has worked well. It provides the necessary information about the estimated value of options grants without creating financial obstacles for those companies offering stock options to their employees.

The IASB tentatively decided last September to move forward with a proposal similar to the one proposed in 1993 and rejected by FASB in 1995. The period for comments on the proposal closed on December 15, 2001, and there is no fixed date for a final decision. Although the panel was seeking comments on ways to value the options, many objections to the proposal to expense the stock options were filed in addition to suggestions on how to value the options. The blue-ribbon consortium mentioned above believes the decision on stock-option accounting could undermine the current consensus that supports the IASB. The proposal being proffered by the IASB is an entirely new standard that no country uses today. The most time-tested and most generally accepted standard is that adopted by FASB in 1995.

The United States and leading European countries may look at this rule as so controversial that these countries may, in least in the near term, go their own ways. But many experts, including analysts at Deloitte and Touche, believe a final stock option accounting standard is inevitable and that “U.S. companies are going to have to deal with this.”

This issue is not only of concern to U.S. companies that offer stock options. European companies also are increasingly relying on stock options to attract and share ownership with their employees. To many international observers, how the IASB resolves this issue will determine if the IASB becomes a real force in setting international accounting standards or whether individual countries decide to go their own routes.

This NCOE Update article was written by National Commission on Entrepreneurship on 2/28/2005

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